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Plunging oil prices

The recent plunge in oil prices raises lots of questions.If you haven’t noticed, the U.S. and world price for oil per barrel have plunged 35.2% and 38.2%, respectively, since June. If stock or bond markets were down by this amount, people would be freaking out.Of course, plunging oil prices sounds like a good thing, right? That means lower costs for fuel at the pump, lower transportation costs with airlines, lower costs to ship goods by rail or truck, lower prices generally, etc.But, a question should be raised in your mind: why are oil prices plunging? Trying to answer that question is what has many market observers scratching their heads.Are oil price plunging because demand is dramatically lower? Oil prices frequently plunge going into recessions as demand dries up relative to supply that remains stable. China is certainly slowing down, and large economies like Europe and Brazil are clearly struggling. Slowing growth is, without doubt, part of the issue. Demand has also declined because high oil prices over the last decade have led to reduced consumption and greater use of alternative sources of energy, like solar and wind. That, too, may be playing a part.Are oil prices plunging because supply is outstripping demand? Shale oil in the U.S. (predominantly) is bringing huge new supplies of oil into the market. High oil prices over the last decade have made it very profitable to find and produce oil. This has made once unprofitable oil in places like the Canadian oil sands and deep sea drilling profitable. Additional supply is definitely playing a part in oil’s recent plunge.But, why has the plunge occurred over the last 5 1/2 months and not before. Declining demand from China, Europe and Brazil did not become hot news over the last 6 months, nor did the increasing supply coming from shale oil, oil sands or deep sea drilling. What, then, has changed?And this brings us to geopolitics. The price of oil is not set in a truly free market. The OPEC cartel has long been the marginal producer of oil, and Saudi Arabia in particular can usually produce oil to set prices where they want. For the last decade or so, Saudi Arabia and OPEC have been happy with oil prices of around $90 a barrel, and they have been quite open in stating that fact.Recently, however, the Saudis have said they think oil could stabilize at $60 a barrel. Now, we have the real culprit. Why do the Saudis want oil prices to be 33% lower than previously? And, here comes the speculative part of my article. Some observers think that the Saudis have all of a sudden decided to make shale oil and other high cost competition unprofitable. This explanation scores high on the international conspiracy front, but would seem strange given the fact that such high cost competition has been quite obvious for some time. Perhaps it took that long for consensus to build within Saudi Arabia?Other observers have noted that Russia’s move into the Ukraine might be the cause. In this interpretation, the Saudis are doing the west’s bidding by increasing supply to put the screws to Russia. It has been said that Russia needs $110 a barrel oil to pay for all its government programs. With that, such an interpretation makes sense although it strains credulity to think that Saudi Arabia would do the west’s bidding, especially considering that it is also said that Saudi Arabia needs $90 a barrel oil to fund its own government programs. Also, the crisis in the Ukraine and Crimea with Russia started right after the Sochi Olympics ended–last February. Why would the Saudis wait four months to put Russia under pressure. Consensus building and political wrangling from the west?Something that did happen last summer as opposed to over the last decade or last February is the rise of the rise of the Islamic State of Iraq and the Levant (ISIL). In fact, in late June, ISIL proclaimed a worldwide caliphate. Around the same time, ISIL took Mosul and threatened to march on Baghdad. The Saudi government lives in fear of an uprising close to or inside their borders because they are themselves a religious totalitarian state. Perhaps the Saudi fear of ISIL or organizations similar to ISIL is what is leading the Saudis to suddenly be comfortable with $60 per barrel oil. Keep in mind that ISIL is funding its uprising with oil it is grabbing and selling on the black market. Making that oil less profitable or unprofitable would clearly put the screws to ISIL and similar followers.What has caused oil prices to plunge over the last 5 1/2 months? It’s probably a combination of the things I raised above: lower demand, higher supply and geopolitics (shale oil boom competition with OPEC, Russia, ISIL). The question now becomes: what happens going forward? How long will the Saudis keep oil prices low? Will that dampen supply and lead to a price spike when the Saudis do let up? How will the rest of the economy or world governments react to lower oil prices? How will that impact the economy as things eventually return to normal?I don’t have answers to those questions, but they will definitely impact world markets and economies over the next several months and years.Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Good analysis, Mike. I hadn't considered this theory but it does make sense. Our pastor just returned from Dubai a few weeks ago, he was born and raised in Saudi Arabia. He said all the Arab nations are extremely fearful of ISIS but have to walk a tight rope so they do not come across as being anti-Islam. Saudi Arabia as well as other gulf states want to hurt ISIS and lowering oil prices certainly does that in a direct and important way.

I wonder how long our U.S. domestic drillers and producers can withstand / tolerate these lower prices and still keep profitable with the new fields they have opened and horizontal drilling? Have you read any estimates on their threshold price per barrel?

On the price per barrel of domestic drillers, I've seen numbers from $50-75 per barrel, but I would guess there are super-efficient drillers with easier formations that can go below $50, and there are others that aren't as efficient or have harder formations to drill that are above $75. I think Canadian oil sands and offshore deep-water will suffer before many U.S. land-based drillers. Here's a provocative question: how long can the Saudis maintain prices at $60 per barrel.